Royal Bank of Canada (USA) (RY), Toronto-Dominion Bank (USA) (TD): Thinking About Buying a Bank? Consider Canada

When American investors consider buying stock of a bank, the first ones that usually come to mind are the dominant forces in American banking. Banks like Wells Fargo & Co (NYSE:WFC), Bank of America Corp (NYSE:BAC), and JPMorgan Chase & Co. (NYSE:JPM) come to mind. But I strongly feel it would be wise for investors to consider one from the Great White North.

According to the World Economic Forum, Canada’s banking system has been ranked the strongest in the world for three years running. In 2012, CNBC released its list of the 50 safest banks in the world. Canada had seven banks in the top 50, more than any other country.

Royal Bank of Canada (USA) (NYSE:RY)

Five heavyweights dominate the banking scene in Canada. In order of market capitalization they are: Royal Bank of Canada (USA) (NYSE:RY), Toronto-Dominion Bank (USA) (NYSE:TD), The Bank of Nova Scotia (USA) (NYSE:BNS), Bank of Montreal (USA) (NYSE:BMO), and the Canadian Imperial Bank of Commerce (USA) (NYSE:CM) rounds off the list.

Dividend discussion

Some of the largest banks in the United States have decent yields. Among America’s five largest banks, Wells Fargo and JPMorgan Chase lead the way with each yielding 3%. Three percent is certainly a respectable yield. But all of the largest five Canadian banks yield more than JPMorgan and Wells Fargo, every single one! Let’s take a look:

Dividend Yield 4.3% 4.0% 5.0% 4.4% 5.2%
Payout Ratio (TTM) 45% 43% 48% 43% 46%
First Dividend (mm/yyyy) 10/2000 9/2000 8/2000 10/1998 9/2000
% of quarters missed(since first dividend) 19.6% 19.23% 15.38% 17.24% 11.54%

All five of these dividends have similar payout ratios, and began paying a dividend around roughly the same time. If I had to pick one of these dividends, I would go with the CIBC. It has the highest yield, and has been the most consistent dividend payer of the five.

Two of Buffett’s favorite bank metrics

Two of the best metrics for getting to the bottom of whether a bank is of a higher quality than its peers are return on assets and return on equity.

Return on assets is a measure the amount of profits the company generates relative to the amount of assets it took to earn those profits.

Return on equity is a measure of  the amount profits a company is able to generate relative to how much equity capital is being utilized by the firm. In both cases, the higher the ratio, the better.

Here’s how the Canadian big five stack up in terms of ROA and ROE. I’ve also included an American bank that is generally regarded as being of high quality, Wells Fargo.

Return on Assets (TTM) .9% .8% .7% .9% .9% 1.7%
ROA avg: 2008-2012 .7% .7% .6% .8% .5% .3%
Return on Equity (TTM) 17.9% 14% 13.9% 16.8% 19.8% 13.1%
ROE avg: 2008-2012 16.9% 17.2% 13.0% 19.4% 14.6% 11.9%

Wells Fargo managed to crush the Canadians in return on assets over the TTM, other than that, WFC doesn’t have much to brag about. Personally, I place more value on five-year averages than one year’s results. Over the past five years, in terms of ROE, The Bank of Nova Scotia has led the way with a scorching 19.4%!

The famous tier 1 capital ratio?

The Federal Reserve of the United States has been conducting annual stress tests since 2009. Whenever they take place, the figure everyone’s eyes are drawn to is the famous tier 1 capital ratio. The tier 1 capital ratio is a gauge of how well a bank could withstand an economic crisis of epic proportions.

Computation of the ratio can get incredibly complex, but the basic idea is this. The tier 1 capital ratio is the ratio of a bank’s core equity capital to risk weighted assets. Just what exactly do those terms mean?